New research busts the myth that credit rating agencies are lazy and biased when it comes to accounting for innovation.

Professor Paul Griffin of the Graduate School of Management at the University of California, Davis, and his co-authors recently examined U.S. credit rating data. With a shift in the U.S. toward a knowledge-based economy, creditworthiness increasingly depends on the success of a firm’s research and development investments and other intangible assets.

“The name of the game in economic growth is innovation,” Griffin said. “America is now second in the race versus China in terms of patents and patent recognition.”

Credit ratings help investors determine who will meet their obligations. The ratings come in the form of letter grades and are meant to represent objective and independent analyses of a firm’s ability to pay its debts.

Griffin teamed up with Hyun Hong from UC Riverside and Ji Woo Ryou from the University of Texas Rio Grande Valley. They compared new data on patent filings and citations to analyses of Standard & Poor’s, Moody’s and Fitch IBCA ratings services. They found sound economic reasons to explain delays by rating agencies in accounting for company innovation.

Specifically, they show that corporate innovation efficiency — measured by the number of patents divided by research and development expenditures — improved credit ratings, though gradually. Their findings were recently published in the Journal of Corporate Finance.

“It wasn’t a question of ignorance or laziness,” Griffin said of the credit rating agencies. “We found that we could explain these trends in ways that represent rational ways to think about it.”

The findings also refute the prevailing view that rating agencies focus more on earnings and sales than innovation and lack clear recognition of how innovation can affect creditworthiness.

“While innovation has sometimes been side-lined in analyses by credit rating agencies,” Griffin said, “the ratings can have global impacts on economic growth.”

The study identified three reasons that credit agencies are slow to pick up on innovation:

• Poorly performing companies pose risks — If a firm already has a low credit rating, the agencies are more concerned with that downside risk than the upside risk in the payoff from innovation. “Credit rating agencies need to focus on what’s important to the creditors, and that is the possibility that they could lose all their money,” Griffin said.
• Not all patents lead to payoffs — The researchers found that firms with patents that led to higher payoffs saw improved ratings. “Rating agencies are not going to take a wild guess,” Griffin said. “They’re going to wait until information confirms that the patent actually is a beneficial patent. They also have a reputation to protect.”
• Accounting quality matters — The response of the agency also reflects the quality of financial information the firm is providing, as well as its sales. “If a firm’s reports are opaque or nontransparent, it is harder to figure out what the payoffs to the patents are,” Griffin said.

Following the global financial crisis, credit rating agencies were accused of colluding with big banks. When it comes to innovation information, however, the study shows there is no such evidence.

“We can rest assured that the credit views of firms with innovations are being properly reflected in credit pricing,” he said. “They’re not being hurt because this technical information is being misunderstood.”

Given this finding of a lag in responding to innovation, Griffin pointed out that corporations may want to call on agencies to act more quickly to improve their ratings.